When I look at events in Europe today, with Ireland getting bailed out and talk of crises brewing elsewhere on the continent, I am reminded of the weeks leading up to the banking crisis in 2008. As the credit crunch began and banks found it increasingly difficult to get access to funding, policy makers faced a choice: deal with the problem in a piecemeal way, or address the root causes immediately.
For too long many policy makers opted to fudge their approach; they dealt with the problem bank by bank and refused to recognize the system’s fundamental flaws.
As a result, we saw Lehman Brothers go bankrupt, Bear Stearns bought up in a fire sale and a major British bank come within hours of collapse.
During that summer I realized that unless we put a firewall in place to prevent the crisis from spreading, we would face a catastrophe in the banking sector and the wider economy. That’s why I took the controversial step of injecting billions of pounds into the banking system to stabilize it. By tackling the fundamental problem, the lack of capital in banks, we stopped a meltdown. It was drastic action, but I have no doubt that it worked.
The same approach is now urgently needed for European economies. It is not enough for the euro zone nations to bail out each economy as it falls into a crisis — they must address the root causes of the continent’s problems.
This hasn’t been the approach so far. In May, Europe eventually faced up to the fact that it had to help Greece, which was finding it increasingly difficult to borrow to cover its debts. But the rescue was far too long in coming, and the United States Treasury deserves a great deal of credit for forcing the issue to a head.
Thanks to the bailout, the immediate crisis was resolved; we bought some time. But that time was not used to put in place a more fundamental approach that would deal with overly indebted European economies.
And so, a little over a week ago, we saw a new crisis: Ireland had to accept that its banks’ debts were so large that it needed help. The European Union and the International Monetary Fund stepped in with a bailout package, and again the immediate crisis was averted.
But did the Irish bailout draw a line under the euro zone crisis? Far from it. Bond yields rose for Portugal, Spain and even Italy, a strong indication that problems remain.
More than anything, the problems in the euro zone have exposed the monetary union’s basic fault line. The euro zone shares a common currency, but the political and economic union that underpins it has a limited ability to resolve disagreements among member states and to take decisive steps to resolve difficulties.
The result is a political crisis alongside the economic one: commentators speak as if the only options are complete political union or the breakup of the euro zone. But the first will not happen, while the second would create many more painful and destabilizing problems. Instead, just as with the banking crisis, Europe must construct a firewall to stop the crisis from spreading.
This will involve two sets of steps. First, action is needed now to provide stability. To that end, the European Central Bank needs to make a firm commitment to buying government bonds from at-risk countries. That’s what it did during the Greek crisis, where its resolve played a key role in returning investor confidence to the bond market. Since then, however, it has sent out increasingly mixed signals about whether it would do so in the future (although last week it did step up its bond purchases, to some effect).
The European Central Bank should be clear that it will continue to intervene to stabilize markets, and it needs to consider going further. During my time as chancellor of the Exchequer I authorized the Bank of England to engage in quantitative easing by increasing the money supply, a step that has been taken twice by the Federal Reserve as well.
Despite the success of our actions, however, the European Central Bank has refused to consider doing the same. It should think again. Quite simply, Europe cannot afford to bump along the economic bottom for the next few years with sluggish growth.
The euro zone states also need to deal with banks carrying unsustainable debt. Last summer Europe carried out so-called stress tests on its banks to see which ones were at risk of collapse. But these tests were insufficient (as I noted at the time). The tests did not pay enough attention to the banks’ interrelationships, not just in Europe but globally. Banks in trouble need to be restructured and broken up, if necessary.
Finally, alongside such preventive measures, Europe needs to step up its contingency planning in case banks wind up failing. The Irish banks are not unique, after all. This means being clear about what sits on a bank’s balance sheet, and what is to be done if a bank becomes insolvent. The lack of such transparency in the case of the Lehman Brothers collapse led to the seizing up of the global finance sector — no one knew who owed what to whom.
The second set of steps is more long term and involves Europe’s accepting two fundamental principles. The first is that austerity alone will not work. It is not enough simply to demand that countries at risk of default immediately shrink their deficits and cut government spending. That approach is self-defeating: inflicting deflationary, painful austerity policies runs the risk of stifling the growth the countries need to pay down their debt and recover.
Today too many European advocates of austerity at all costs stand virtually unchallenged. Their solution is similar to that of dealing with troubled banks one by one: it is a fudge, addressing just one part of a much larger problem.
What is needed instead is a balanced approach in which deficits are brought down quickly, but not in such a way as to destroy the economic or social fabric of those countries. The pace of deficit reduction needs to match the capacity of the private sector to pick up the slack.
The second principle is that countries with heavy debt burdens need more than just a bailout. Markets need to see that these countries have some hope of being able to manage their debt burdens in the future, especially after seeing their governments nationalize the balance sheets of collapsing banks.
Consumers in these countries, seeing their economies in crisis, will not want to spend money or borrow more. Companies will be wary of making investments. So growth, and the means of meeting countries’ debt burdens, must come from exports.
That means in the medium term, larger euro zone countries will need to increase their own spending to balance the contraction in demand they are imposing on their crisis-stricken neighbors. Unfortunately, today the opposite is occurring: major European economies are undertaking their own austerity measures, shrinking demand for imports at home. This approach offers the peripheral countries no way out, and unwieldy transfer payments of one form or another, like bailouts or other aid packages, risk becoming unavoidable.
I have spoken with too many European politicians who, when I ask them where growth will come from in the future, say they can’t be sure. But without a clear path forward, we will see minimal growth for Europe’s stronger economies; for those in danger already it could be disastrous.
We cannot go on like this. The crisis in the euro zone is the single largest threat to the fragile global recovery we are now seeing. And this is not just a problem for Europe. It matters to us in Britain, as well as to the United States and Asia.
At last year’s Group of 20 meetings in London, the participating countries agreed to stabilize the international banking system and to stimulate the world economy. Further progress was made in Pittsburgh six months later. There was real political will to do what was necessary.
That momentum has now been lost, and it will not be regained without greater involvement from the major economies. Decisive action, confronting the underlying causes of this crisis, is now imperative.
Alistair Darling, a member of the British Parliament and chancellor of the Exchequer from 2007 to 2010